Don't write off China even though growth is slowing

Has an investment story ever suffered such a dramatic fall from grace?

A couple of years back, China was unstoppable, dragging the West out of its self-inflicted financial crisis, piling up foreign reserves as it prepared to leapfrog America, sucking in the world’s commodities to build a magnificent urban future for a billion happy rural migrants.

Today, no one has a good word for the place. It’s a social and demographic time bomb, its banks and shadow banks nothing but a giant Ponzi scheme, housing is a bubble waiting to pop and the country’s an environmental catastrophe to boot. How could we have been so naïve?

On Monday, GDP figures for the second quarter will most likely show a further deceleration in growth and the doomsters will smugly say they told us so.

Speculation is rife that the Chinese authorities already have quietly cut their own growth forecast, only months after setting a 7.5pc target in March. Lou Jiwei, China’s finance minister, let slip last week in Washington that China was aiming for 7pc growth this year.

Did he make a mistake? Was he confusing this year’s growth with the 2011-15 five-year plan? Or was he deliberately softening us up for a disappointing number on Monday?

The reality is that growth is progressively slowing and the government is not about to do anything to stop it. That’s because, early in its 10-year term, the new regime is less interested in headline growth than in much-needed structural reforms that shift the economy from depending on exports and investment to a more sustainable domestic consumption-driven model.

It is concerned about the quality of growth, not its quantity, and if that means the GDP figure slips to 6pc or so, then so be it. We’d better get used to that, because when an emerging economy weans itself off growth through infrastructure spending, output growth typically falls by between a quarter and a half. With investment spending already massively higher as a proportion of GDP than it ever reached in either Japan or Korea, a significant drop in growth seems inevitable.

There are clearly problems with the Chinese economy. Leverage is at extreme levels in absolute terms (with total debts of around 230pc of GDP, according to Credit Suisse) and well above the trend growth rate of the past 25 years. No wonder the interbank lending rate has been so volatile in recent weeks. Despite this massive growth in credit, however, manufacturing indicators are weakening and with the labour force contracting – so putting further upward pressure on wages – China is becoming less and less competitive. Does this matter? Clearly it is a drag on sentiment, and it will continue to weigh on sectors and companies exposed to the investment and export slowdown, such as mining equipment companies and capital goods manufacturers.

But the flip-side of the changing shape of the Chinese economy is an ongoing consumer boom that will continue to throw up interesting opportunities for investors focused on the consumer discretionary, technology and healthcare sectors that look most likely to thrive in a lower-growth but more sustainable economy.

A key focus for investors today is what is being described as Urbanisation 2.0, a reform of the hukou system of household registration that will give newly-arrived migrant workers in cities access to affordable housing and social security.

This is good news for healthcare, utilities and consumption-related sectors. A move up the value chain by companies priced out of global markets is encouraging consolidation within fragmented industries and a focus on the environment is seeing inefficient polluters closed down, allowing better-run companies to succeed them.

So, there remain opportunities in China. But the main attraction for me today is that this is an increasingly minority position.

Slower growth and structural problems are well understood and that means they are priced into the world’s most unpopular market. The best years to invest in Japan were not in the 1950s and 1960s when growth was highest but in the 1970s and 1980s, when expansion had settled to a more sustainable level. The time to invest in anything is when the conventional wisdom says you are mad to do so.

Tom Stevenson is an investment director at Fidelity Worldwide Investment. The views expressed are his own. He tweets at @tomstevenson63